To what extent do marginal tax rates matter for individual decisions to work and invest? The answer is essential for public policy and its role in shaping economic growth. The strand of the empirical literature that uses tax return data, surveyed in Saez, Slemrod and Giertz (2012), finds that incomes before taxes react only modestly to marginal tax rates and that the response is mostly situated at the very top of the income distribution.

So what does this mean? A lot depends on how one defines “modestly,” though it’s worth noting that even very small changes in growth – if sustained over time – can have big impacts on prosperity. Which, in turn, has a significant effect on government finances.

And I have no objection to the assertion that upper-income taxpayers are most sensitive to changes in tax rates. After all, people like me who rely on wage and salary income don’t have much opportunity to alter our compensation in response to changes in tax rates.

That being said, Professor Mertens’ research suggests that conventional analysis has underestimated the impact of tax rates on the general population.

This paper adopts a macro-time series approach that addresses the endogeneity of average marginal tax rates in novel ways and permits insight into dynamics. Based on this approach, I find large income responses to marginal tax rates that extend across the income distribution. …The empirical results in this paper are relevant for several important debates. First, they reinforce the findings by a number of recent macro studies of large effects of aggregate tax changes on real GDP both in the US and internationally. The results imply that raising marginal tax rates to resolve budget deficits comes at a high price and that a proportional across-the-board tax cut provides successful stimulus that does not necessarily lead to greater income concentration at the top.

But I’m digressing. Let’s return to Professor Mertens’ research. He also produced some interesting results about tax rates and high-income taxpayers.

Many of the postwar tax reforms have made particularly large changes in top marginal tax rates. This variation in top statutory rates may be used to estimate the effects of a hypothetical tax reform that only alters marginal tax rates for the top 1%. …The specification…displays the response to a one percent rise in the net-of-tax rate of the top 1% in the income distribution. …The tax cut leads to significant increases in average top 1% incomes, which rise on impact by 0.52 percent and by 0.97 and 1.02 percent in the following two years, after which there is a gradual decline. …the cut in top 1% tax rates leads to a statistically significant increase in real GDP of up to 0.34 percent in the third year. …There are also spillover effects to incomes outside of the top 1%. Average incomes of the bottom 99% rise by 0.15 percent on impact and by up to 0.35 percent in the third year.

So we learn that lower tax rates for the “rich” are good for the economy and also beneficial for the living standards of the general population.

Why, then, would anybody want to impose high tax rates? Here’s a hint from the study.

In other words, the rich get richer faster than the non-rich get richer when the top tax rate is reduced. So if you’re driven by class-warfare animus, you may decide that you’re willing to hurt poor and middle-class people in order to prevent upper-income taxpayers from realizing a bigger share of the economy’s increased output.

Unfortunately, politicians generally are motivated by a desire to maximize votes and power, not by what’s logical.

Which is why, when I’m doing educational outreach on Capitol Hill, I often make an extra effort to explain that a bigger economy – enabled by small government and free markets – is the same as a bigger tax base.

That’s far from a pure libertarian argument, to be sure, but it’s not easy when you’re trying to convince the foxes that it doesn’t make long-run sense to deplete the henhouse.

11 Responses

Since you have covered the effects of higher tax rates on individual incentives, I’ll skip that and go directly to effects on product or service prices.

A FairTax rate of 25% or a Flat Tax of 25% adds 33.3% to the final cost of the product or service over net cost plus net profit. If some portion of the embedded tax cost could be eliminated, prices could be lowered, stimulating economic activity and improving exports. Conversely, if any taxes are raised, whether on labor through payroll taxes or high income individuals or investors, prices will be pushed higher. Maybe because of competitive pressures not high enough to fully pay the additional taxes, but higher; thereby cutting demand and slowing the economy.

It is not unreasonable to look at inequality. After all we do judge things on a relative scale. Were that not the case, we would all be happy, living in an age where even the “poor” are wealthier than 99.9% of all humans who ever lived on planet earth.

That being said, the cost/benefit of even minute changes in growth rate are staggering. Had humanity grown a mere tenth of a percent more per year in the past two millennia, we would already be living in a fantastic futuristic world, free of cancer and such ailments and surrounded by things are still unimaginable to us today. Had the world grown a mere tenth of a percent less, we would still be living in the preindustrial age, with an average life expectancy of less than forty, dying of tuberculosis and similar ailments.

The immediate inequality is visible to most people. The “what might have been” under different growth rates is ignored by ninety nine percent of voters.

Huge long term benefits of compounding growth, vs immediate modest benefit of redistribution. We know what wins at the polls. Especially when snake skin economists like Paul Krugman tell you that you can have both high growth and less inequality, if you ever left things to government experts and ignored basic human nature — or successfully managed to change such fundamental nature through leftist preaching: Finally convincing people to leave their families and hobbies every morning to go work inside four walls for the benefit of distant others. The dream lives on, the decline continues.

Reblogged this on Public Secrets and commented:
The takeaway: lower tax rates for “the rich” — the job creators and business builders– are better for all concerned, rich and not-rich. Too bad empirical results never seem to penetrate the Left’s need to be “fair.”

The upper income earners, being more reliant on investment income, also see a dramatic reduction in income when markets turn down. When a jurisdiction puts more of their eggs in the basket of the higher income earners, they can find a massive reduction in revenue when markets tank. More of a revenue stream from those who have a predictable stream of salary/wages means less revenue impact from investment market fluctuations.

[…] In the grand scheme of things, it presumably doesn’t make much difference what days people are born and when they die. But when we apply these lessons to the broader economy, it turns out that taxation has a huge impact on economic opportunity and prosperity. […]

[…] you change relative prices to make productive behavior more rewarding. And this happens when you reduce the tax code’s penalty on work compared to leisure and when you lower the tax on saving and investment compared to […]